Question

circumstances under which agency costs are likely to occur. detailed explaination please.

Answer 1

A brief understanding of agency problems & agency costs

• What Is the Agency Problem?

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.
Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal's or client's best interest.
One famous example of the agency problem is that of Enron, one of the largest companies in the United States. Enron's directors had a legal obligation to protect and promote investor interests but had few other incentives to do so. Many analysts believe the company's board of directors failed to carry out its regulatory role in the company and ignored its responsibilities, causing the company to venture into illegal activity. The company went under following an accounting scandal that resulted in billions of dollars in losses.

Despite being a multi-billion dollar company, Enron began losing money in 1997. The company also started racking up a lot of debt. Fearing a drop in share prices, Enron's management team hid the losses by misrepresenting them through tricky accounting manipulations such as special purpose vehicles (SPVs), or special purposes entities (SPEs)—resulting in confusing financial statements.
The problems started to unfold in 2001. There were questions about whether the company was overvalued, leading to a drop in share prices from over $90 to under $1. The company ended up filing for bankruptcy in December 2001. Criminal charges were brought up against several key Enron management officials.

• What are Agency Costs?

Agency costs are internal costs incurred due to the competing interests of shareholders (principals) and the management team (agents). Expenses that are associated with resolving this disagreement and managing the relationship are referred to as agency costs.

Agency costs typically arise in the wake of core inefficiencies, dissatisfactions and disruptions, such as conflicts of interest between shareholders and management.

Agency costs include any fees associated with managing the needs of conflicting parties, in the process of evaluating and resolving disputes. These costs arise from the separation of ownership and control. Shareholders want to maximize shareholder value, while management may sometimes make decisions that are not in the best interests of the shareholders (i.e., those that benefit themselves).

Two categories of agency costs:

1. Costs incurred when the agent (management team) uses the company’s resources for his or her own benefit.
2. Costs incurred by the principals (shareholders) to prevent the agent (management team) from prioritizing him/herself over shareholder interests.

For example, agency costs are incurred when the senior management team, when traveling, unnecessarily books the most expensive hotel or orders unnecessary hotel upgrades. The cost of such actions increases the operating cost of the company while providing no added value to shareholders.

Agency costs are further subdivided into direct and indirect agency costs.

There are two types of direct agency costs:

1. Corporate expenditures that benefit the management team at the expense of shareholders.
2. An expense that arises from monitoring management actions to keep the principal-agent relationship aligned.

The first type of direct agency costs is given above, where the management team unnecessarily books the most expensive hotel or use luxuries that do not add value to shareholders.

An example of the second type of direct agency cost is paying external auditors to assess the accuracy of the company’s financial statements.

Indirect agency costs represent lost opportunities. Say, for example, shareholders want to undertake a project that will increase the stock value. However, the management team is afraid that things might turn out badly, which might result in the termination of their jobs. If management does not take on this project, shareholders lose a potentially valuable opportunity. This is an indirect agency cost because it arises out of the shareholder/management conflict but does not have a directly quantifiable value.

The agency cost of debt is the increase in the cost of debt or the implementation of debt covenants for fear of agency cost problems. Agency cost of debt generally happens when debt holders are afraid the management team may engage in risky actions that benefit shareholders more than bondholders. For fear of potential principal-agent problems in the company, debt suppliers may place constraints (such as debt covenants) on how their money is used.

Shareholders who disagree with the management decisions may be less inclined to hold on to the cos. stock over a long time. Also a particular event may trigger mass sell off by the shareholders resulting in large decline in the stock price. Additionally this might demotivate new investors from investing into the co. resulting in further decline of the share price.
In cases where the shareholders become miffed with the actions of a company’s top brass, an attempt to elect different members to the board of directors may occur. The ouster of the existing management can happen if shareholders vote to appoint new members to the board. This can result in significant financial costs.

The most common way of reducing agency costs is to implement an incentives scheme. There are two types of incentives: financial and non-financial.
Financial incentives are the most common incentive schemes & they are the performance related monetory rewards to the management team.

Examples of financial incentives are:

• Stock options: Allow the person to buy a particular number of co. shares at a predetermined price
• Profit-sharing: Management receives a percentage of the company’s profits

Examples of non-financial incentives are:

• New office or workspace
• Training opportunities
• Recognition from co-workers
• Corporate car

Incentives themselves are actually agency costs. However these incentives, if implemented correctly, would prevent the management from acing in his or her own interests (which would likely incur higher costs).